Working Paper No. 933 Defaultnomics: Making Sense of the Barro-Ricardo Equivalence in a Financialized World by Lorenzo Esposito* Bank of Italy and Catholic University of the Sacred Heart, Milan and Giuseppe Mastromatteo Catholic University of the Sacred Heart, Milan July 2019 *The views expressed are those of the author and do not involve the responsibility of the Bank of Italy. This work can be seen as an extension and a deepening of previous papers and presentations. A partial anticipation of the present research is also in Mastromatteo and Esposito (2017b). The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2019 All rights reserved ISSN 1547-366X ABSTRACT The 2008 crisis created a need to rethink many aspects of economic theory, including the role of public intervention in the economy. On this issue, we explore the Barro-Ricardo equivalence, which has played a decisive role in molding the economic policies that fostered the crisis. We analyze the equivalence and its theoretical underpinnings, concluding that: (1) it declares, but then forgets, that it does not matter whether the nature of debt and investment is public or private; (2) its most problematic assumption is the representative agent hypothesis, which does not allow for an explanation of financialization and cannot assess dangers coming from high levels of financial leverage; (3) social wealth cannot be based on any micro-foundation and is linked to the role of the state as provider of financial stability; and (4) default is always the optimal policy for the government, and this remains true even when relaxing many equivalence assumptions. We go on to discuss possible solutions to high levels of public debt in the real world, inferring that no general conclusions are possible and every solution or mix of solutions must be tailored to each specific case. We conclude by connecting different solutions to the political balance of forces in the current era of financialization, using Italy (and, by extension, the eurozone) as a concrete example to better illustrate the discussion. KEYWORDS: Barro-Ricardo Equivalence; Financialization; Default JEL CLASSIFICATIONS: E62; H23; F65 1 1. INTRODUCTION: THE MEANING OF THE BARRO-RICARDO EQUIVALENCE (BRE) Public debt has the unenviable record of being blamed for almost every economic disease, at least since David Hume and Adam Smith. In Europe, the process of economic and political unification has the war against public debt at its core, especially after the Maastricht Treaty. The 2008 crisis has worsened the problem because the states were forced to bailout the banking system, thereby increasing public debt. In fact, “public debt has reached unprecedented levels in advanced economies. It has become today the most pressing and difficult policy challenge that Western governments have to face” (Banque de France 2012, 3). Overall financial leverage is at dangerous levels and recently the Governor of the Bank of Italy pointed out: “Additional risks are associated with the high level of global debt, in both private and public hands, which in the third quarter of 2017 reached 245 per cent of GDP, 35 percentage points more than at the end of 2007” (Visco 2018a). The dynamics are well synthesized in figure 1. Figure 1: World Public Debt-to-GDP Ratio Source: Cottarelli (2012) 2 On the theoretical side, the war against public debt coincided with the war on countercyclical policies. In the mainstream paradigm, a market economy is fundamentally stable and financial markets are efficient. So, public institutions are better left out of the picture, apart from an independent central bank that should ensure low inflation. In particular, expansionary fiscal policies are useless: “Any government expenditure crowds out private investment; therefore, loose fiscal policy may in fact be contractionary” (Caballero and Krishnamurthy 2005). This was the macroeconomic wisdom before the crisis. In this framework, the Barro-Ricardo equivalence (BRE) has played a decisive role. The original article by Barro (1974) explained that it is futile to use public money to boost the economy because private investment crowds it out. Since the problem is public debt, not debt as a whole, these theories, and the BRE in particular, favored an interpretation of debt dynamics that acted as a smokescreen for policymakers. In a scene of the Italian movie Ecce Bombo (1978), a group of youngsters waiting for the sunrise on a beach near Rome are taken completely by surprise as the sun rises at their back (they were facing westward toward the sea). Placing all the emphasis on public debt, the BRE has put economists and policymakers in the same situation, preventing them from having the right perspective on modern finance. The world, and Europe in particular, is paying a heavy toll for this mistake. In fact, while according to the BRE, it is public debt that was the danger and financialization (i.e., the growth of private debt and financial leverage) was of no concern. The mainstream paradigm does not even have a proper place for money, banks, and finance (Freixas and Rochet 2008), and practically every financial innovation was considered good (securitization, credit derivatives, the originate-to-distribute-model, etc.). Since the 1980s, the weight of the financial system on the world economy has been growing apace. Though mainstream economics did not have any viable explanation for this trend, it was considered a positive development because a bigger role for finance meant more growth and more innovation (King and Levine 1993; Rajan and Zingales 1998). When, in the same historical period, financial crises started to punctuate the world economy, they were explained as being caused by a lack of finance, too many corporate rules, too high corporates taxes, too much state intervention, or crony capitalism (Bell 2008). When the crisis struck at the very heart of the world financial system, these “explanations” fell apart. Although many economists continued to suggest laissez-faire solutions, central banks and governments rushed to rescue the banking system and the world economy. 3 Although much has been said about deleveraging, after the banking collapse of 2008, debt has grown even faster (Dobbs et al. 2015; IMF 2018). As for public finance, the public debt trajectory has worsened because of the bank bailout and the crisis itself (Cecchetti, Mohanty, and Zampolli 2010). However, no one seems to be worried about a significant increase in the interest rate; on the contrary, there are studies on how to adjust to a world that is cornered in the zero lower bound (Agarwal and Kimball 2015; IMF 2017). This is because economic agents (states included) have such a high level of financial leverage that a strong increase in the interest rates is ruled out. Before the crisis, central banks (especially the US Federal Reserve) had been criticized for keeping the rates too low. Fed Chairman Alan Greenspan consented happily because he believed in free-market recipes (Greenspan 2009), but besides his personal opinions, the Fed and other central banks did it because they had no choice, as was clear when they attempted to raise rates and the market panicked. This is even truer now. The critiques of fiscal dominance (Bayoumi et al. 2014) are tantamount to the idea that central banks, when deciding their policies, can overlook the $60 trillion in public debt and at least three times as much total debt. In the “new normal”—as the IMF defines the present environment for monetary and fiscal policy—the leverage ratio is structurally high and monetary policy has contributed to making it sustainable by keeping down interest rates and buying public debt. In such a situation, is the central bank really independent? What will be the role of fiscal and monetary policy in the future? Another dimension of the discussion is public debt. Is it a threat to growth and financial stability? How will we deal with mounting public debt? In this paper, we deal with these topics by analyzing the BRE assumptions and conclusions vis-à-vis the default. In section 2, we extend the theoretical side of the issue, showing that in the BRE world, default is the optimal (or rather the only) outcome for public debt, and we analyze the theoretical consequences of this conclusion. In section 3, we discuss the real world situation vis–à-vis the solutions to high levels of public debt, showing that it is not possible to draw general conclusions on the issue. In sections 4 and 5, we relate practical issues to the specific Italian situation to make the discussion more concrete, although we do not expect to outline a thorough scenario for a possible Italian default. 4 2. THE BRE WORLD 2.1 Assumptions and Empirical Truths “Neither Ricardian equivalence nor the Modigliani-Miller theorem hold in the real word.” (Reichlin, in Corsetti et al. 2015) The BRE comes with a host of implausible assumptions, as acknowledged even by its supporters. Should we discard it because of them? Let us start by recapping its main assumptions. 1. The application of Say’s law implies a full utilization of productive resources, hence no involuntary unemployment, nor idle resources in the system (Arestis and Sawyer 2003).